The Good, the Bad, and the Ugly of Variable Universal Life Insurance (VUL)

[Editor’s Note: The following guest post was submitted by Grant Bledsoe, CFA, CFP® of Three Oaks Capital Management, a fee-only registered investment advisory firm. Three Oaks Capital Management is on our list of recommended advisors, however, this is not a sponsored post. I have written about variable universal life insurance policies many times in the past. While there are endless variations of cash value life insurance policies, the general principles are the same- an expensive life long insurance policy combined with some sort of cash value/investment feature that can be borrowed against or that provides cash (gains fully taxable at ordinary income tax rates) if the policy is surrendered. For a sampling of bad experiences with cash value policies, check out this thread on the forum. It would behoove anyone considering buying one to read that entire thing, especially if you are under the misconception that these are good investments. As always, if you really understand how these work and still want the policy, knock yourself out. But if you’re like most readers, once you realize how they work you won’t want one, even if you already own it.]

A fundamental concept of personal finance that Dr. Dahle and I share is that insurance and investing do not mix. Insurance companies are famous for creating products meant to be “all-in-one solutions” for your financial needs. Whether you’re seeking life insurance to reduce mortality risk, a tax-deferred savings vehicle, guaranteed income, or any number of other things, rest assured that there is a complex insurance product available to meet your needs.

The catch, of course, is that the more bells and whistles in an insurance contract, the more expensive it tends to be. And in the vast majority of circumstances, you’re better off purchasing the least costly insurance policy you can find to meet your risk management needs and keeping your investment portfolios completely separate. While there can be compelling tax advantages to insurance-based products, those benefits are usually negated by the costs.

If you’re a devout (or even casual) reader of the site, you know that this type of compensation structure leads salespeople to come up with creative ways to sell insurance-based products. In this circumstance, the person they were working with recommended that they fund a variable universal life insurance policy as a “personal deferred comp plan.” The rep positioned the idea as a way to provide a death benefit to cover mortality risk while offering a tax-free savings vehicle for retirement and their kids’ college tuition.

Is a “personal deferred comp plan” via VUL a legitimate way to accomplish these objectives? It can work favorably given a very specific set of circumstances. But in my experience, those circumstances are quite rare, and in my client’s case, there were far better options. This post will explore why.

Variable Universal Life: The Good

Taxation

With a VUL policy, your premium payments cover the cost of life insurance, the selling agent’s commissions, and the insurance company’s costs and margin. After those are accounted for, whatever is left goes toward a cash value. Being a “variable” policy, you can invest the cash value in a selection of mutual fund like subaccounts.

The value of the policy will grow over time, as long as you continue making premium payments and have positive investment returns. This investment growth is tax-deferred until you take withdrawals from the policy. If you die prematurely, your beneficiaries are entitled to the death benefit. If you don’t, you can pull money out of the accumulated cash balance later, presumably in retirement. Hence the positioning as a personal deferred comp plan.

The taxation of VUL policies is their primary advantage. The IRS considers withdrawals to come out basis first. That means you can withdraw up to the total amount of your contributions to the policy tax-free. Once you’ve retrieved your basis in a policy, all that’s left is investment growth. Withdrawals from growth are added to your taxable income for the year.

This is where the “tax-free savings” claim comes into play. Rather than withdraw funds from a variable policy directly, a popular way to avoid taxation is to take them as loans against the accumulated cash balance. VUL policies allow you to borrow money from the insurance company, using the policy’s cash value as collateral. Policy loans accrue interest (usually at a reasonable rate) but are not taxable as income.

So, if structured properly, a VUL policy could be used as a tax-free deferred comp vehicle. You’d put money into the policy now & let it grow tax-free until retirement. When it comes time to take money out, withdrawals up to your basis come out tax-free. All others are technically loans, which are also tax-free. Plus, you’d have the death benefit in the meantime if you died prematurely.

Grant Bledsoe, CFA, CFP

VULs: The Bad

Policy Lapse

One problem with this strategy has to do with when and how the policy terminates. If you die while the policy is active, the insurance company takes the collateral you’ve pledged (the actual cash value) to close out your loans and pays any death benefit left over to your beneficiaries.

But if the policy lapses before you do, there can be significant tax implications. If your policy’s value exceeds your total contributions, you’d have a gain in the policy. This gain would be taxed as income, just as if you’d taken a direct withdrawal.

What’s worse, if a VUL policy lapses with outstanding loans, the total loan balance is immediately taxable as well. And if you’re using a VUL policy as a tax-free deferred comp vehicle, you’d likely have a significant loan balance over time. In my client’s case, the policy illustration showed a balance of $1.8M in the year they turned 80. That could be a massive tax bill if things don’t go well.

The most common reason a VUL policy would lapse is if there’s not enough cash value left to pay policy expenses. Remember, this cash value is subject to volatile market performance just like any other investment. So, if you took a significant amount of money out of a VUL policy before experiencing negative investment returns, it’s possible the policy could be at risk of lapse.

Realistically you’d have a couple of options to keep the policy in force if it were at risk of lapse. The easiest would probably be to reduce the death benefit, as doing so would also reduce the policy’s annual costs. Of course, you’d need to prove insurability again if you needed to increase the death benefit again in the future.

You could also make additional contributions and just cover the policy costs out of pocket. Personally, this option would be unappealing. I’d hate to be backed into a corner and forced to pay a rising annual VUL policy fee just to avoid a huge tax bill.

Investment Limitations

While tax-deferred growth is attractive in VUL policies, you’re limited to the investment options offered by the policy. My client’s policy offered 75 different choices, including risk-based portfolios, target-date options, and a few index funds. Unfortunately, the annual operating expense of the investment choices (including the index funds) ranged from 0.5% to 2.6% per year.

There are policies around now that offer decent investment lineups, including low-cost index funds and/or DFA options. This policy was not one of them. But even if you did have a stellar investment menu now, the selection could be limiting in the future. If some attractive new asset class is popularized ten or fifteen years down the road, the insurance company would need to formally add it as an option before you could invest. I don’t know any VUL policies today that list peer to peer lending or venture capital as investment options, for example.

The Ugly

Cost

In my client’s case, the policy was structured for seven years of $50,000 annual premium payments, at which point the policy would be fully funded. Of the $50,000 year one premium, $6,866 went toward various administrative & insurance fees, leaving $43,134 in cash value before any account growth. This didn’t include the operating expenses of the investment options.

This particular policy offered a feature that recoups a portion of these initial costs if the policy was surrendered in the first 14 years. Even with this feature, the return in the first few years of the policy is very low. Assuming a 6.5% net return on the investment options, the policy illustration showed an ROI of:

3.91% after year 1

3.08% after year 2

2.60% after year 3

Low policy returns in the first few years of a contract is a common characteristic and huge drawback of VUL. In my client’s case, the illustrated returns were low throughout the contract. By year 30 the net return to the policyholder was only 4.98% per year, thanks to the annual increases in the cost of insurance. Even in the highest tax bracket, I’m confident a taxable account would perform better over the same time horizon if invested properly.

Compensation to Selling Agent

Lastly, insurance agents make a killing when selling VUL policies. Depending on the company, VUL commissions payable to insurance agents generally range from 70% to 100% of total first-year premiums. And remember, in my client’s case they’d be contributing $50,000 per year for seven consecutive years. Do that math on that, and it’s not hard to see why these products are sometimes sold unscrupulously. And aside from the agent’s perspective, the fact that insurance companies are willing to pay up to 100% of year one revenue tells you how profitable (i.e. expensive) they are over the life of a policy.

Can VULs Work as a Deferred Comp Plan?

Sure, theoretically. But a lot of things would need to go right for a VUL policy to result in a better outcome than buying term insurance & investing the difference. You’d basically be betting that the good (the total tax benefits) offered by a VUL policy will outweigh the bad (the extra costs) over the rest of your life. For this to be true several different stars would need to align:

You’d need to be in a high tax bracket. Or expect future tax rates to skyrocket, based on our national debt level or some other reason.

You’d need to already be maxing out your contributions to all the tax-advantaged retirement account options available to you. The benefits of these accounts will trump the benefits of VUL policies any day of the week after costs.

You’d need to find a policy that offers solid, inexpensive investment options. You’d probably be using them for a very long time.

In my experience, it’s quite rare to find a situation where variable universal life would be a good fit as a retirement account or personal deferred comp plan. For my client, surrendering the policy was a far better option. They weren’t maxing out contributions to their 401k or utilizing a 529 plan yet, they were able to obtain a term policy to replace the death benefit, and there were no surrender charges for ditching the VUL.

Moral of the story? Proceed with caution when considering variable universal life. If you’re evaluating a policy as a retirement account or personal deferred comp plan, you’re probably better off separating your insurance and investing vehicles.

Have you been sold a VUL as a retirement account or personal deferred comp plan? Do you think doctors are starting to get wiser about not buying insurance that they don’t need? Comment below!

13 comments

I sat down at lunch a month or two back and had a conversation with someone who made a living selling whole life insurance products like this. After poking holes in it for an hour, I asked this financial advisor two questions that I found enlightening when answered:

First, I asked, “How often do you think someone would outperform a whole life policy if they got term and invested the difference in a taxable account with diversified index funds?”

His honest answer, “Probably 100% of the time.” His argument, though, was that most doctors are not disciplined enough to do this… so, instead of educating them about financial discipline and the need to fill up tax-advantaged space and then filling up a taxable account….he thought selling them a forced WLI product was the better alternative.

Second, I asked, “What percentage of doctors do you think need a whole life insurance policy?”

He said, “100%. Every single person needs one.”

This one surprised me, because he genuinely believed it. It blew my mind given his honest answer to the first question.

Come to find out he liked to use WLI as his version of “fixed securities” that would be safe to withdraw from in retirement. He had zero percent of his portfolio (and it sounds like many of his client’s portfolios) in bond index funds or in municipal bonds, TIPS, or treasury bills . Or really any other more secure investment options. His WLI policy took the place of these.

They do a great job of making these products sound incredible. And anyone who is approached about one should do an equally impressive job vetting them before they turn them down.

I think that’s a lousy argument. If you aren’t disciplined enough to fund an IRA/401(k)/taxable account for decades why would you be disciplined enough to fund a whole life insurance policy and not borrow against it? Those are the people who cash out or surrender their policies (usually with a loss) early on. You’re not helping them. In fact, the low returns make it less likely that they’ll stick with the plan.

I also see WLI as not at all equivalent to bonds. For example, what is the expected return on bonds in their first 5 years? Well, it’s positive. What is the expected return on whole life insurance in the first 5 years? It’s negative. That’s not the same thing. They’re not equivalent. Sure, if you hold on to a well designed (and most aren’t) whole life insurance policy for 5 decades, you’ll end up with a bond-like return (usually 1-2% lower). But that seems like a silly reason to buy a policy when you could just buy bonds.

I’ve covered both of those arguments in my myth series, but I’m not surprised to see someone who sells these things actually believes them. As Upton Sinclair said, “It is difficult to get a man to understand something when his salary depends upon his not understanding it.”

At first I thought there was no post today but I happened to swing by to check the forum and saw it on the homepage. I remembered when all those issues happened with everything going to spam last fall. I thought it was something like that but nope not in spam.
Best of luck figuring it out. I look forward to my morning reading.

I think the RSS feed was wonky this morning. I didn’t post to the RSS feed until 0400 and I think the email goes out with all new RSS content at 0200. I suspect you’ll all get two emails tomorrow morning. We’ll see.

I had a problem with my email not going out today, too. I had to set up a new email with the same RSS feed. Not sure why that happened. I use Mail Chimp. My posts go live at 0400 and the email is usually sent at 0500 EST.

I was sold one of these a few years back, soon after finishing training. (Despite my better half’s objections and concern about putting so much money away every month towards it, I decided to do it.)

About 4-5 years in, as I got more financially literate, I saw that it was a pretty crummy “investment” and started to do quite a bit of research into it and how to get out of it.
Where I ended up, however, was to just keep it for the time being. At that point, I had already put in >$200,000, and my surrender charge would be ~$50k. After I saw that, I couldn’t quite bite that bullet, so looked into it some more, ran some more numbers.

What I ended up doing instead was to optimize the policy that I had. I sold all of the high expense funds and consolidated into a handful of more diversified and cheaper funds. Also, I looked into how much a term policy would cost me at that point, and that yearly premium was a couple thousand for the same death benefit. By keeping the VUL, I was just getting those premium payments that I would have to make towards a term policy “waived”. I stopped making any further contributions to the VUL. I had them run some illustrations for me, with no further contributions, 4-5% predicted returns, other conservative parameters, etc. and found that the policy likely wouldn’t default for 20-30 years.
I had unknowingly overfunded the policy, but now, those funds had appreciated enough to cover the M&E charges and insurance charges. Sort of like building a nest egg and withdrawing 4%, the >$200k that I had put in was sufficient to cover the annual fees for long enough time (hopefully) for me to be financially independent. Then, at that point, I would no longer have a surrender charge and then would do a 1035 exchange. Fortunately, these last few years the market has kept up with expenses in the VUL. If the market takes a turn down, then the VUL cash balance would suffer, so I have to keep a periodic eye on the cash balance.

I wouldn’t get the VUL policy again, if I could go back in time. But, just as an example as someone who was sold one, and ended up keeping it instead of cashing out.

This exact thing happened to me. I am doing exactly what you are doing as well. I was too busy with my practice and did not think that an agent for my hospital group would steer me wrong. Lived and learned. In retrospect, I would have just got term life and invested in a taxable account after maxing 401k, 457b, 401a and backdoor roth.

Would these policies permit one to pay a small premium in year one, when the commissions are extracted, and up the premium later? Or do they simply take out the same commission amount no matter when it is paid?

If the commission is simply based on whatever is paid in year 1, then one might be able to make the performance better through this approach.

Still hard to see this as worthwhile even for those who are maximizing their retirement plans and college savings. Hard to see the fees working even if one were able to find a, relatively, low expense ratio index fund.

For people who are decades into these policies and taking loans, they should be able to reduce the market risk by shifting the portfolio to short term bonds.

With whole life you can maximize the use of Paid Up Additions (which have a lower % commission) to increase the returns and I suspect you can do something similar with VUL, but you’d have to talk to someone who sells them to see how easy that is to do. Obviously it isn’t to their benefit to do so (since it lowers commissions) so most policies don’t do that sort of thing.

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